The 7 Rules of Using Options Foolishly

We're delighted that more and more Foolish investors are becoming familiar with options. These powerful portfolio tools can be used to generate steady income, get better buy and sell prices on stocks, protect profits, leverage upside, profit on falling prices, and much more. Used simply and consistently, the right mix of options strategies can enhance a portfolio's returns, and make money in any market.

Both of us have been using options for years to accomplish these things and more. Since 2009, we've been doing so as co-advisors in Motley Fool Options, where more than 90% of our closed positions have made members money. To show you how we do it -- and how you can use options at home to earn steady returns -- we've put together a short dialogue on our seven core tenets.

No. 1: Valuation first, options second.Jim: I've long believed in the power of overlaying carefully conceived and constructed options strategies on top of my stock portfolio. The intelligent and profitable use of options is rooted in business-focused investment analysis and valuation, a core Foolish principle. Remember, options are derivatives -- that is, they derive their value from something else (the underlying stock). It would seem prudent, then, to understand that "something else."

Jeff: That's right. We're not options "traders." If you're trying to simply buy and sell options as a trader, hoping to make money on price movements, you're destined to fail. The costs of trading are high, prices move rapidly, and options are designed to lose value steadily for the owner unless the underlying stock moves in a big way. When we use options, we have a clear thesis about the underlying stock, a desired outcome, a predicted time frame, and a back-up plan or exit strategy. Finally, we write options most of the time, selling them for income. We're the "house," and someone else is the gambler.

No. 2: We think long-term, even as we use short-term strategies.Jim: A common perception is that options are exclusively short-term vehicles. Not necessarily so, dear Fools.

Jeff: Because we're stock-based investors, our options strategies have the long term in mind. For example, if we write puts that expire in just three months, we're prepared to own the stock for the long haul if those options are exercised. And if we buy an option, it usually doesn't expire for a few years. This is what sets Motley Fool Options apart: We keep stocks involved in our service if that's the best strategy, and we think long term. We consider every company -- and its valuation -- before we implement an options position on it.

Jim: Sometimes we do like short-term strategies. Other times, we specifically seek to profit from more complex option strategies that take shape over several years (and may evolve over time). In a world where so-called long-term stock ownership can mean as little as three years, some of our strategies easily match that.

No. 3: We're option writers more often than option buyers.Jeff: As I alluded to, option writers (also called sellers) have many advantages. We're paid the option premium on day one -- and can keep it. We can choose a strike price that grants plenty of leeway for stock movement, while still providing a profit in the end. If we need more time, we can usually roll our strategy forward to a later month. If a trade works against us, the underlying stock can buy us more time (with put writing), or a profitable exit (with covered-call writing).

On the other hand, the odds are stacked against option buyers: They pay the option premium out of pocket, and they must be right about the direction, timing, and velocity of an underlying stock's price movement. If they're not, the option steadily loses value, and they're left staring down a potential 100% loss.

That said, the most money that option writers can earn is the premium payment, while option buyers have unlimited upside, so both strategies have strong benefits. We'll often combine the two, writing options and using the premium to buy other options -- the best of both possible worlds.

When we're option buyers, we usually buy long-dated contracts (some expiring up to 2-1/2 years after they're issued). We want as much time as possible for our thesis to play out, without overpaying or risking too much capital. But when we write options, we tend to choose those that expire in just two to six months. As sellers, we want our contracts to lose value rapidly -- they do so the nearer they get to expiration -- and we want the flexibility to restart our strategy with new contracts every few months. At all times, we're prepared to think and act with an eye on the long term.

No. 4: Diversification if necessary, but not necessarily diversification.Jim: In my personal option portfolio, I use a mix of long- and short-term, bullish and bearish strategies. I have several favorite underlying stocks -- businesses I understand and believe in that generate lots of cash, and whose management teams I trust. In such cases, I repeatedly use strategies designed to take advantage of my understanding of the company's valuation. I believe in applying disparate strategies overlaid on the same underlying stock, as the situation warrants, with a mix of time frames, market expectations, and goals (income versus capital gain, say). You'll see us outline these goals and intents ahead of time, for each and every position.

No. 5: We stay focused.Jim: I'm a competitive guy, so I want to be right every single time. (I don't recommend playing Trivial Pursuit with me.) However, we don't have crystal balls. Sometimes, a company does something bizarre, or has a bad quarter. Sometimes, the economy starts sucking wind, taking businesses, fine and foul alike, down with it. Stock prices at such times can move quickly, and option prices (in percentage terms) can move even quicker. So losses will occur.

Jeff: Our disciplined approach keeps us from acting on emotions. Option prices are volatile, and it's easy to get excited or distraught by weekly, or even daily, price moves. But we'll stay focused on the underlying business, and base our decisions on these fundamentals. As long as our initial thesis is in place, and our option strategy is still viable, we'll likely stick with our trade, even if we see extreme volatility in the meantime. This approach gives our options trades a much greater chance for success.

Jim: It's true: How we react to losses is what ultimately drives our success. The time limitations that options impose often suggest that taking a small loss earlier is preferable to taking a total loss at expiration. A bad outcome in one position should be mitigated by good outcomes in other positions. And we'll have a lot of good outcomes. In that context, we also look to harvest gains, where appropriate. The occasional options 10-bagger is wonderful -- but not at a cost of a bunch of losing positions. A series of simple base hits -- singles and doubles -- is equally satisfactory.

No. 6: We go our own way.Jim:Motley Fool Options picks its underlying stocks from five top Fool newsletters, but our stance may differ from that of the original newsletter. With our options strategies, we may go bearish, and look to profit from a stock's fall. We may be bullish even though a newsletter jettisons a pick. But whatever we do, it's always based on business analysis and valuation.

Even seemingly contradictory recommendations aren't necessarily mutually exclusive; a bearish position on a long-term winner can still make money in the short term. Our aim is to be correct -- defined as making money -- the vast majority of the time. And we place overwhelming importance on achieving absolute gains on each position rather than beating a market benchmark. If we demand gains and accuracy of ourselves, our members' portfolios should ably surpass the market's returns.

No. 7: We believe in the power of community.These philosophies help guide us as we use options Foolishly -- to make us better stock investors, and increase our profits yearly. As a final note, we'd be remiss not to emphasize the importance of the Foolish community. We're message-board raconteurs, who love being on the boards, answering questions, asking questions, engaging in debate, and simultaneously educating and learning from you, our members. The community discussion boards in Motley Fool Options are a very valuable part of the service, and we hope to see all of you there.

--Jeff Fischer and Jim Gillies, Motley Fool Options co-advisors

If you're interested in hearing more of these strategies, Motley Fool Options and Motley Fool PRO are hosting FREE introductory programs this month, called Options Whiz and PRO Academy. Click here for more details and to sign up!